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A non-grantor trust is a powerful tax-planning tool. Millions of Americans have one (or more) of these trusts. But you may have never heard of them. Or you may be wondering what exactly they do. In this article, we provide background on trusts in general, what non-grantor trusts are, and why some people — particularly people with relatively high incomes and/or net worths — can benefit from them.
What is a Non-Grantor Trust?
A trust is a legal arrangement in which one person (the grantor) transfers property to a person or entity (the trustee), who controls that property for the benefit of another person (the beneficiary). For income-tax purposes, there are two main types of trusts: grantor trusts and non-grantor trusts. A non-grantor trust is a particular type of trust that is treated as a separate taxpayer for income tax purposes. This sets it apart from grantor trusts, which are ignored for income-tax purposes, just like single-member LLCs. Non-grantor trusts file taxes and report income themselves. Whether a trust is a grantor trust or a non-grantor trust is based on the specific terms and provisions in the agreement creating the trust. (Here is a deep dive comparing both structures).
How are Income Taxes Applied to Non-Grantor Trusts?
Non-grantor trusts are subject to a special form of income taxation. Here’s the basic idea: Each trust is taxed on the income it retains. In general, when a non-grantor trust makes distributions to the trust’s beneficiaries, it gets a corresponding deduction against its realized income. The beneficiaries then get a K-1 from the trust (like they would if they had income from an investment), and they pay any tax associated with that distribution. If the trust distributes an amount equal to its income-tax liability or greater, the trust won’t owe any tax on that income. Instead, the beneficiaries will pick up the tab. If the trust distributes an amount that is less than its total taxable income during that year, then the beneficiaries will pay tax on the amount distributed and the trust will pay tax on the trust’s remaining income. If the trust doesn’t make a distribution in a given year, the trust will pay all the taxes on the realized income and the beneficiaries won’t get K-1’s. This way, there is never double taxation; it’s just a question of whether the income tax is paid at the trust level or at the individual beneficiary level.
For example, let’s say Bob sets up a trust for his daughter, Susie. In 2024, the trust generates $200,000 of interest income. Of that amount, $130,000 is distributed to Susie individually. Susie receives a K-1 reflecting $130,000 of income; she pays tax on that income. The trust pays tax on the $70,000 that isn’t distributed to Susie. Note that if Susie is in a low tax bracket, she might not owe very much tax on that $130,000. There’s a good chance she’s in a lower tax bracket than Bob.
This two-tiered system applies with respect to most forms of trust income — including dividends, rental income, and interest income. It may or may not apply with respect to capital gains income, depending on the language in the trust agreement and certain elections made by the trustee.
State Income Tax Treatment of Non-Grantor Trusts
About half the states either don’t have an income tax or don’t apply their income tax to non-grantor trusts provided that certain conditions are met. People in high-tax states are often drawn to these trusts because it’s possible to set them up in states that do not tax trust income and as a result avoid state income taxes on assets owned by the trust. It’s almost like an alternative to moving to Florida! Over time, people in high-tax states can save a ton in state income tax by shifting some of their asset-based income to non-grantor trusts.
It’s important to understand that income from assets in a high-tax state, like rental income from California commercial real estate, is going to be taxed by that high-tax state no matter what. But income that is not intrinsically tied to a particular state, like most dividend or interest income, is not subject to state income tax when earned by a non-grantor trust that is a resident of a no-income-tax state like South Dakota. Likewise, a Californian could set up a non-grantor trust in South Dakota, move a Nevada commercial property into it, and avoid having to pay California income tax on the rental income, since the rental income is sourced to Nevada, not California.
That said, the income-tax savings is somewhat dependent on where the beneficiaries live. If the beneficiaries live in high-tax states, they’ll pay state income tax on the distributions. From a state-income-tax perspective, a non-grantor trust will make the most sense for someone who is not planning to make distributions to beneficiaries in high-tax states in the near future — either because the beneficiaries are in low-tax states, or because the grantor wants to reinvest the proceeds inside of the trust.
Non-Grantor Trust Federal Tax Brackets
Non-grantor trusts have their own federal tax brackets. They’re taxed at the exact same rates as individuals, but in an effort to prevent high-income people from setting up dozens of trusts and shifting a portion of their income into each trust, Congress compressed the brackets. In simple terms, this means that trusts reach the top tax bracket at lower income levels than individuals. For example, in 2024, a non-grantor trust hits the top federal tax rate of 37% after just $15,200 of income. But an individual single person doesn’t hit that 37% rate until they have over $609,350 of income! A married couple filing jointly doesn’t pay 37% until over $731,200 of income.
That said, often the high-income taxpayers setting up non-grantor trusts are already in the highest federal tax bracket, so the fact that the trust they’re setting up are also in the highest tax bracket doesn’t make a difference: They’d be paying the same 37% tax rate regardless.
Also, recall that these trusts are only taxed on the income they generate and retain. If they generate income but then distribute that income to beneficiaries in the same tax year, the beneficiaries (who may be in low tax brackets) will receive K-1s and pay tax on that income in lieu of the trust paying tax. If a trust isn’t paying income taxes because it distributes its income, its tax bracket doesn’t matter.
Tax Benefits of Non-Grantor Trusts
There are a number of reasons why these structures are popular, and many center around the tax savings they generate. Here are some of the big tax benefits of non-grantor trusts:
State Income Tax Savings. In California, the top marginal state income-tax rate is 13.3%. In New York City, the top rate is 14.776%. In South Dakota, the top marginal state income-tax rate is 0%. Setting up a trust in a state like South Dakota, and then putting investments that generate lots of investment income inside of that trust, can save a grantor’s family a lot of income tax over time.
QSBS Savings. For founders or early startup employees who have QSBS-eligible stock, perhaps the biggest benefit of non-grantor trusts is the additional QSBS exclusion they receive. These types of trusts are eligible for their own $10 million QSBS exclusions — a single QSBS-stacking non-grantor trust can save a family tens of millions of dollars of income tax. In some cases, individuals can set up multiple non-grantor trusts. For example, someone with three children might set up three separate non-grantor trusts, generating a total of $30 million of additional federal and state QSBS exclusions. Setting up non-grantor trusts can be particularly valuable for individuals with QSBS stock who live in one of the five states that apply their state income tax to QSBS stock — California, New Jersey, Pennsylvania, Mississippi, and Alabama.
Estate Tax Savings.Certain irrevocable trusts, including most non-grantor trusts, can help wealthy people save on estate taxes. This is because the assets in the trust (including any appreciation after the assets are contributed) are not included in the grantor’s taxable estate when the grantor dies. The current federal gift and estate tax exemption is 40% on assets over $15 million per person, but many rich families have significantly more than that. The sooner these individuals and families put assets in non-grantor trusts that are outside of their taxable estates, the more wealth they can pass to their heirs estate-tax free.
Miscellaneous Federal Deductions. Non-grantor trusts get their own federal deductions and exemptions such as the $10,000 state and local income tax deduction, excess business loss deductions, mortgage interest tax deductions, Section 199A small business tax deductions, and more. Collectively, these tax benefits can be quite significant.
Low-Bracket Beneficiaries. As discussed above, non-grantor trusts can pay tax themselves or distribute income to beneficiaries, so that the beneficiaries pay the tax. This optionality is valuable, particularly if the beneficiaries are themselves in low tax brackets.
Lower Tax Rates on First Several Thousand Dollars of Income. In 2024, the first $15,200 of trust income is taxed at rates below the top tax bracket. This benefit is less significant than the other tax benefits that non-grantor trusts receive, but still, for taxpayers who would otherwise be paying tax at the highest marginal rate, the tax savings from this small tax break alone can pay for much of the annual administration costs of a non-grantor trust.
Non-Tax Benefits of Non-Grantor Trusts
There are two other major non-tax benefits of irrevocable trusts. These benefits apply to both grantor and non-grantor trusts:
Asset Protection. In the United States, litigation is one of the biggest risks to wealth preservation. A lawsuit can undo years of savvy financial management. Here, non-grantor trusts can help. Because an irrevocable trust is a separate legal person, it is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win their lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, irrevocable trusts can help shield inherited assets from a divorcing spouse.
Control. Trusts allow people to put rules and conditions around how the money they transfer to a trust is used. For example, they can set up a trust for their grandchildren that doesn’t pay out until a certain age, only pays out under certain conditions or limits how much can be distributed over a certain time frame. This lets individuals pass on wealth in a controlled way.
Limitations and Tradeoffs of Non-Grantor Trusts
Non-grantor trusts have enormous tax and non-tax benefits. But they also have certain drawbacks and limitations:
Liquidity and Access.These trusts are less liquid than grantor trusts. You can borrow from a grantor trust whenever you want, without any income-tax consequences. You can borrow from these trusts too, but the interest (which has to be charged at IRS-mandated minimum rates, typically 2%-5%) will be taxable. You also can’t swap assets out of a non-grantor trust without generating taxable gain. You can invest the money in the non-grantor trust as you see fit, including in your own business. But generally, by transferring assets to a non-grantor trust, you are losing most access to that money. At that point, it becomes essentially the beneficiaries’ money (though the beneficiaries won’t actually control the money unless you want them to). That said, from the beneficiaries’ perspective, a non-grantor trust can be quite liquid.
Beneficiary Limitations. A related point is that it’s difficult (but not impossible) to name your spouse as a beneficiary of a non-grantor trust. If you want your spouse to be a beneficiary it requires several family members and/or friends to be named as trust beneficiaries and vote on distributions from the trust. In some cases, these “distribution committee” members may be subject to tax liability as a result of their participation on the distribution committee. That’s why most people name their children, grandchildren, other family, or friends, but not their spouses or themselves, as the beneficiaries of their non-grantor trusts.
W-2 Income. You can’t shift your wage income to a non-grantor trust in order to avoid state income tax. For that, you’d have to actually move to a low-tax state.
Estate Tax. Non-grantor trusts are highly income tax efficient, and they are also an excellent vehicle for moving assets out of a grantor’s estate and reducing a family’s future estate tax liabilities. But they are less efficient at reducing estate tax than grantor trusts. To learn more, you can read through this article on intentionally defective grantor trusts.
Tax Deferral. Non-grantor trusts can’t defer federal capital gains tax. If your goal is simply to minimize capital gains tax on the sale of an appreciated asset, a charitable remainder unitrust may be a better fit. But if you’re attracted to the various other benefits of non-grantor trusts, like the state income tax benefits and the estate tax benefits, a non-grantor trust may be an excellent fit.
Need some help to understand if a Non-Grantor Trust is the right fit for you?
Non-grantor trusts are a tool often used by high-net-worth individuals and families to minimize income and estate taxes, maintain privacy, protect assets, and provide structure for passing on wealth to the next generation. Below are some case studies that can help you understand how people incorporate non-grantor trusts into their tax plans:
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Mani is the founder and CEO of Valur. He brings deep financial and strategic expertise from his prior roles at McKinsey & Company and Goldman Sachs. Mani earned his degree from the University of Michigan and launched Valur in 2020 to transform how individuals and advisors approach tax planning.
